Inflationary Gap Vs Deflationary Gap
At full employment level, the equilibrium level of an economy is defined, in which the level of demand is equivalent to the level of income. When the aggregate demand is in excess of the productive potential of the economy, the gap is inflationary. Whereas the variance between full employment and the actual level of output, then that variance is a deflationary gap.
Table of Contents
- What is an Inflationary Gap?
- What is Deflationary Gap?
- What is Deficient demand?
- What is Excess demand?
- What is Full employment?
- Measures to correct excess or deficient demand
- Difference
- Quick Comparison
- Wrap Up
What is an Inflationary Gap?
The inflationary gap is a macroeconomic term. It gauges the variance amidst the actual aggregate demand for output. In essence, real gross domestic product and the output level that would prevail if the economy is operating at full employment, i.e. potential GDP. It is when the actual aggregate demand is greater in comparison to the potential aggregate demand required.
You might be wondering- Why the variance is termed an inflationary gap.
Well, it triggers those factors which can cause inflation or shoots up the general price level without increasing the level of output.
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What is Deflationary Gap?
A deflationary Gap indicates the variance amidst actual aggregate demand for output in an economy. In essence, Real GDP and the maximum potential level of aggregate demand needed to set up full employment. It occurs when the actual aggregate demand is lower than the aggregate demand required.
We call the gap a deflationary one because it drives those factors which give rise to deflation in the economy. That is the fall in the general price level.
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What is Deficient demand?
When the aggregate demand is for an income level less as compared to the full employment level, the situation of deficient demand prevails, which results in a deflationary gap.
What is Excess demand?
When the aggregate demand is for an income level, more as compared to the full employment level, the situation of excess demand prevails, which causes the inflationary gap.
What is Full employment?
Full employment implies a state where aggregate demand is equal to aggregate supply. And the people who are able and willing to work are getting employment at the existing rate of wage.
Measures to correct excess or deficient demand?
Government can adopt several measures with the intent to correct the excess or deficient demand. These measures are:
- Change in government spending.
- Change in taxes.
- Regulate the availability of credit by changing monetary policies.
- Change in the rate of interest, i.e. CRR, SLR, Bank Rate, Repo Rate, Reverse Repo Rate, etc.
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Difference Between Inflationary and Deflationary Gap
The following points explain the difference between inflationary gap and deflationary gap:
Meaning
At a full employment level, if the aggregate demand surpasses aggregate supply, then the difference between the two is an inflationary gap. However, at the full employment level, if the aggregate demand is lesser in comparison to aggregate supply, then the difference between the two is the deflationary gap.
Demand
The demand causing an inflationary gap is the excess demand. In comparison, the demand which results in a deflationary gap is deficient demand.
Causes
The inflationary gap occurs due to the factors such as:
- Rise in the propensity to consume, resulting in an increase in the consumption of the households
- Rise in government expenditure,
- Increase in export demand,
- Rise in credit facilities leading to an increase in the demand for private investment,
- Increase in disposable income,
- Increase in investment.
The determinants behind the deflationary gap are:
- Fall in the propensity to consume, resulting in a decrease in the consumption of the households
- Fall in government expenditure
- Decrease in export demand due to the global recession
- A fall in credit facilities leads to a decrease in demand for private investment,
- Decrease in disposable income,
- Decrease in investment due to financial crisis or banking collapse.
Effect on General Price Level
In the case of the inflationary gap, the general price level increases, but the same will decrease in the deflationary gap.
Level of Output
When there is an inflationary gap, the level of output is constant, whereas there is a low level of output in the case of a deflationary gap.
Unemployment
Deflationary gap results in a reduction in the level of investment, which may result in involuntary unemployment because of the decrease in planned output. As against, in the case of the inflationary gap, there is no effect on employment.
How to cope?
As a corrective measure, the government can take resort to expansionary fiscal policy to overcome the deflationary gap. Whereas to cope with an inflationary gap, contractionary fiscal policy can be used by the Government.
Quick Comparison: Inflationary Vs Deflationary Gap
| Basis | Inflationary Gap | Deflationary Gap |
|---|---|---|
| Concept | Inflationary Gap reflects the excess of aggregate demand, than the level of demand required to enable full employment equilibrium, in the country's economy. | Deflationary Gap indicates the shortage of aggregate demand than the level of demand required to enable full employment equilibrium in the country's economy. |
| Occurs when | AD > AS | AD < AS |
| Demand | Excess demand | Deficient demand |
| Causes | Rise in the propensity to consume resulting in the increase in the consumption of the households. | Fall in the propensity to consume, resulting in a decrease in the consumption of the households. |
| Rise in government expenditure. | Fall in government expenditure. | |
| Increase in export demand. | Decrease in export demand, due to the global recession. | |
| Rise in credit facilities leading to an increase in the demand for private investment. | Fall in credit facilities, leading to a decrease in the demand for private investment. | |
| Increase in disposable income | The decrease in disposable income. | |
| Increase in investment. | Decrease in investment due to financial crisis or banking collapse. |
|
| Effect on General Price level | Due to excess demand, the general price level tends to rise. | Due to deficient demand, the general price level tends to fall. |
| Effect on Output | Constant | Low level of output |
| Effect on Employment | No effect on the employment level. | Reduction in the level of investment, leading to involuntary unemployment, because of the decrease in planned output. |
| Measure to Improve | Contractionary Fiscal Policy | Expansionary Fiscal Policy |
Wrap Up
As a result of a deflationary gap, the economy’s resources are not utilized in full, and they remain idle, which causes unemployment and the output level is low.
Further, in the inflationary gap, the economy operates at a level over and above the full employment level. And because of the shortcoming of the economy to fulfil the increased demand, the average price level in the economy rises, which causes inflation.
